Excessive risk-taking by large banks was among the main causes of the 2008–09 financial crisis. This column argues that the antidote to excessive risk-taking should come from the elimination of the subsidies of the banking charter and the implicit promise of bailout in case of major losses, and the introduction of strong incentives for management and shareholders to preserve the capital of their bank. This requires deep changes in Basel prudential rules.

Excessive leverage and risk-taking by large international banks were among the main causes of the 2008–09 financial crisis and the ensuing sharp drop in economic activity and employment. Enormous costs were borne by taxpayers and societies at large. In reaction, world leaders and central bankers undertook to overhaul banking regulation, including by rectifying the failed Basel prudential rules with the new Basel III Accord. Many scholars have commented on the proposed reforms, especially the US’s Dodd-Frank Act (eg Acharya and Richardson 2011).

Europe is now considering how to transpose the new Basel III Accord, with the proposed Capital Requirements Directive IV, now before the European Parliament and Council. In our study published last week (Carmassi and Micossi 2012) we argue that these reforms are not enough; they fail to correct the three critical shortcomings of Basel prudential rules, namely:

Reliance on banks’ risk management models for the calculation of capital requirements.

These are opaque and open to manipulation.

Lack of public accountability of supervisors.

Given the opacity of solvency rules, the supervisors may stand beside their regulated entities in delaying loss recognition and ‘gambling for resurrection’, thus raising the ultimate cost of bank failures for taxpayers.

Weak market discipline.

Clear metrics of capital strength are not available to investors and the public at large.

Opacity of capital requirements

It is an established fact that in the post-Lehman experience, banks that failed showed regulatory solvency ratios higher than those of banks that stood in the crisis without need for help (IMF 2009 and Haldane 2011). In their evaluation of banks’ internal models, FSA (2010) shows that internal models produce widely divergent risk assessments of identical portfolios, making them unusable for any objective evaluation of risk exposures. The latest example is Dexia, the Franco-Belgian banking group, which in 2011 passed stress tests with flying colours just before collapsing.

Notes: Total assets of US banking groups and Credit Suisse include gross derivatives positions. Therefore, data for these banks do not reflect those published in their balance sheets, which under US GAAP report net positions in derivatives. The leverage ratio is defined as total assets/regulatory capital. The average and standard deviation are calculated on unweighted data. Source: Annual reports and Basel II Pillar 3 documents.

The data in Table 1 show that this macroscopic failure is not haphazard, but is the result of the varying share, in banks’ balance sheets, of risk-weighted assets – that is, capital-absorbing assets as calculated by large international banks with their own internal risk-management models. As may be seen, the banks with higher prudential ratios are also those with higher total leverage – ie the ratio between total assets (or balance sheet total) and regulatory capital.

The models used by banks in the calculation of risk-weighted assets suffer from fundamental technical flaws that have been exposed by a blooming literature (see Dewatripont et al 2010) but are ignored by Basel regulators. Among other things:

The models are estimated from non-stationary time series and thus have weak predictive value for large changes in the state variables;

They are almost by assumption unable to account for systemic risks, when expectations converge and correlations between portfolio performances rise dramatically; and,

They actually create incentives for banks to concentrate their exposures in the tail of risk distributions in order to economise capital, thus raising the probability of rare catastrophic events actually happening.

Furthermore, the opacity of capital rules leaves supervisors exposed to political pressures to protect their banks in difficulty out of public sight. No surprise then that their discretionary powers to validate banks’ internal models and correct model results have been used quite often to protect national champions, rather than their depositors and investors.

Finally, being unable to read capital indicators, depositors and investors must rely on supervisory assessments in the evaluation of banks’ capital strength, muting their already weak incentives to monitor the behaviour of their bank. In such conditions, it is no wonder that market discipline, under the Pillar 3 arm of Basel rules, has not played a meaningful role in disciplining bank management and shareholders.

Basel III

The Basel III Accord has tightened capital requirements and has introduced new liquidity (short-term) and funding (medium-term) requirements, but capital requirements are still calculated with reference to risk-weighted assets and even broader national discretion. And supervisors remain free to decide whether, when, and how to intervene in problematic banks.

The proposed Capital Requirements Directive IV has weakened Basel III even further by making the introduction of an ‘absolute’ capital back stop – which at all events would only apply after 2018 – non-binding and removing the 3% target level. At the same time, it has introduced a ‘maximum harmonisation’ ceiling on total regulatory capital, with the transparent goal of protecting undercapitalised ‘core’ European banks.

Our proposal

In our study, we put forth proposals that deal with each of the weaknesses in the Basel approach that have been described. Our recipe is the following:

Scrap internal models and risk-weighted assets, in Pillar 1, and set capital requirements as a straight ratio between common equity and total assets (in line with Hellwig 2010 and Atkinson and Blundell-Wignall 2012). The new capital ratio should be raised to between 7% and 10% of total assets, based on systemic stability considerations; a market-based indicator of capital strength should be used as a reference in both Pillar 2 (supervisory review) and Pillar 3 (market discipline);

Use the market-based indicator above, in Pillar 2, to sort out weak banks and bind supervisors to a set of predetermined corrective actions of increasing severity, triggered by multiple (unweighted) capital thresholds below the main statutory requirement. In order to eradicate moral hazard, the system must be ‘closed’ by a mandatory procedure for bank resolution when the minimum capital threshold is not achieved;

Complement solvency rules with the obligation for banks, under Pillar 3, to issue a substantial amount of debentures convertible into equity. These securities should be designed so as to create strong incentives for bank managers and shareholders to issue equity at an early stage, when capital weakens, in order to pre-empt conversion (Calomiris and Herring 2011).

Our proposals apply to all banks, including large international banking groups; we see no need for special treatment of large banks, provided capital rules are applied on a fully consolidated basis. Also, once the perverse incentives behind excessive risk-taking by bankers are removed, we see no need for specific liquidity or funding ratios. Liquidity and maturity transformation can be handled as part of the supervisory review under Pillar 2. Similarly, while each of these measures has merits in combating moral hazard, there is no need to forbid specific operations by banking groups (eg the Volcker rule) or to ring-fence certain activities (as under the Vickers Report proposals).

Conclusion

In summary, we argue that the antidote to excessive risk-taking should come from the elimination of the subsidies of the banking charter and the implicit promise of bailout in case of major losses, and the introduction of strong incentives for management and shareholders to preserve the capital of their bank. The Basel III Accord and the Commission CRD IV proposal do not go far enough. Their entire approach needs fundamental rethinking.

Director General of ASSONIME; Professor at the College of Europe; Member of the Board of CEPS, BNL – BNP Paribas and CIR Group; and Chairman of Scientific Council of the School of European Political Economy, LUISS